The frontline in the debate over pricing bonds can be found in the analysis of two opinionated pundits. In the bulls’ camp is David Malpass, chief economist at Bear Stearns, who argues in an op-ed in today’s Wall Street Journal (subscription required) that the “U.S. expansion has been strong and steady despite the warnings of fragility, the repeated claims of a slowdown, and the fear of China (as intense as the Japan fears of the 1980s).” Taking the opposing view is Bill Gross, chief investment officer of Pimco, the giant bond shop in Newport Beach, Calif. “This recovery is different,” Gross writes in a newly published essay, “because it was spawned and subsequently nurtured on the back of asset appreciation alone.”

Finding corroboration, or dissent, depends on which market you’re reviewing. Gold, for example, seems inclined to favor the Malpass view of the world. Despite fears of an economic slowdown, the price of the precious metal has remained buoyant in recent weeks. Although gold’s price slipped yesterday, it’s up more than 5% since the end of May. This despite crude oil’s climb of more than 16% to new record highs month-to-date through June 27. Crude’s bull run, we’re told by some, will take a toll on the economy, thereby cooling the fans of inflation. Gold bugs, it would appear, have yet to buy into that argument.
Ditto for Malpass, who observes “U.S. growth has averaged a fast 3.9% pace since the initial 7.4% tax-cut-related growth celebration in the third quarter of 2003. Thanks in large part to smaller businesses, U.S. unemployment has fallen to 5.1%, with wage and salary income growing at a 10% annual rate in the revised fourth-quarter data.” Nonetheless, cries of a looming slowdown are on the march, he laments, as are increasing calls for the Fed to call off its ongoing campaign of rate hikes, which presumably will resume on Thursday when the Federal Open Market Committee meets again. “The recent decline in bond yields is being presented as a likely economic slowdown and a justification for the Fed to stop hiking rates,” he notes. But history suggests something else, he concludes: yield declines in the past two years have led to growth.
Malpass expects more of the same this time around. But one man’s ceiling is another man’s floor. Pimco’s Gross counsels readers to be suspicious of the current recovery, very suspicious. The reasoning is tied to the source of the economy’s current strength, namely, decisions made in the aftermath of 9.11, when policy makers opted to engineer asset appreciation by way of injecting liquidity into the economy by way of fiscal and monetary means. This government-induced pump priming “would be the vehicle of choice to engineer a recovery until domestic investment and concomitant job growth kicked in,” Gross writes. He goes on to note,

Greenspan and company have high hopes that investment and then employment will ultimately kick in and work their self-sustaining magic one more time, but jobs and investment these days go to Asia at the margin, and domestic animal spirits have been squelched by the looming inevitability of reduced returns on risk capital in a low interest rate world.

As a result, Gross reasons, “This recovery is on fragile legs because it is asset-appreciation-based and that future asset appreciation is vulnerable based on the weakening stimulative power of interest rates.
Judging by the yield on the benchmark 10-year Treasury bond, the fixed-income set tends to agree with Gross. Indeed, the 10-year’s yield is below 4%, a neighborhood that’s been occupied this month for the first time with gusto since March 2004. If the economy’s poised to hold its own, if not accelerate its growth rate, there are few takers of that theory in the bond pits.

Good thing, suggests David Gitlitz, chief economist at TrendMacrolytics. Buying into the weak-economy theory by way of rising oil prices is something less than foolproof, he argues in a missive to clients yesterday. “We find arguments supporting the notion that higher oil prices justify the Fed at this week’s meeting tilting toward a less assertive posture barren of substance,” he writes, charging that worries over rising oil prices as a threat to the expansion “has been significantly overdone.”
Sixty-dollar-a-barrel oil is nearly one-third lower than the early-1980s price of crude in real (inflation-adjusted) terms, Gitlitz continues. “Moreover, with efficiency improvements and fuel substitution in the intervening years, the economy is more than 25% less oil-intensive than it was then.” He’ll have to rethink those assumptions at some point if oil keeps rising, but for the moment the economy’s staying the course of growth.
Indeed, demand for oil shows no signs of letting up, at least on the trading floor of the New York Mercantile Exchange. If and when the demand for oil begins to recede, all bets are off, Gitlitz concedes. On that score, keeping a close eye on China’s economic growth will do wonders for deciding the future path of oil in the foreseeable future. If the Middle Kindgom’s economy cools sufficiently any time soon, the reversal of fortune threatens to take more than a little air out of crude’s pricing support in the near term.
But even those who worry about a stumble in China’s economy aren’t of one mind when it comes to inflation, i.e., that it’s doomed to fade. Consider Joachim Fels, Morgan Stanley’s fixed-income economist in London, who today notes that Chinese authorities are “trying to clamp down on the property bubble,” which could lead to slower global growth. High oil prices may do no less as well, he adds. Nonetheless, an unexpected jump in inflation, particularly in the U.S., “worries” Fels. The main reason: “I think markets are wholly unprepared for such an outcome. While real bond yields are already very low, suggesting that bond investors anticipate slow growth, the recent decline in market-based inflation expectations implies that a pick-up in inflation would genuinely surprise markets.”
What might cause an uptick in inflation? Higher oil prices combined with a slowdown in productivity growth, the latter being brought on by rising unit labor costs, Fels argues. True, globalization is keeping a lid on such a rise, he acknowledges. “However, domestically produced services account for a much larger chunk of the consumer basket than manufactured goods, and that’s where the productivity slowdown should lead to rising inflation pressures.”
For all the back and forth, Mr. Market is forced to grapple with the immediate question: deciding what side of the debate will move the Fed when it convenes on Thursday? The recent rise in gold prices suggest that the Fed should continue to err on the side of caution and keep raising Fed funds. The bond market could hardly disagree more. Clarity is coming. In what form and when is the mystery.